Chapter 1: Cost-Volume-Profit Relationships

Learning Objectives

After studying this chapter, you should be able to:

1. Distinguish between variable and fixed costs.
2. Explain the significance of the relevant range.
3. Explain the concept of mixed costs.
4. List the five components of cost-volume-profit analysis.
5. Indicate what contribution margin is and how it can be expressed.
6. Identify the three ways to determine the break-even point.
7. Give the formulas for determining sales required to earn target net income.
8. Define margin of safety, and give the formulas for computing it.

To manage any size business you must understand how costs respond to changes in sales volume
and the effect of costs and revenues on profits. A prerequisite to understanding cost-volume-profit
(CVP) relationships is knowledge of how costs behave. In this chapter, we first explain the
considerations involved in cost behavior analysis. Then we discuss and illustrate CVP analysis. The
content and organization of the Chapter are as follows.

1.1. Variable and Fixed Cost Behavior and Patterns

The starting point in cost behavior analysis is measuring the key business activities. Activity levels
may be expressed in terms of sales dollars (in a retail company), miles driven (in a trucking
company), room occupancy (in a hotel), or dance classes taught (by a dance studio). Many
companies use more than one measurement base. A manufacturer, for example, may use direct labor
hours or units of output for manufacturing costs and sales revenue or units sold for selling expenses.
For an activity level to be useful in cost behavior analysis, changes in the level or volume of activity
should be correlated with changes in costs. The activity level selected is referred to as the activity
(or volume) index. The activity index identifies the activity that causes changes in the behavior of
costs. With an appropriate activity index, companies can classify the behavior of costs in response

1
 to changes in activity levels into three categories: variable, fixed, or mixed
Variable Costs: - Variable costs are costs that vary in total directly and proportionately with changes
in the activity level. If the level increases 10%, total variable costs will increase 10%. If the level of
activity decreases by 25%, variable costs will decrease 25%. Examples of variable costs include direct
materials and direct labor for a manufacturer; cost of goods sold, sales commissions, and freight-out
for a merchandiser; and gasoline in airline and trucking companies.
A variable cost may also be defined as a cost that remains the same per unit at every level of
activity.
Fixed Costs: - Fixed costs are costs that remain the same in total regardless of changes in the
activity level. Examples include property taxes, insurance, rent, supervisory salaries, and
depreciation on buildings and equipment. Because total fixed costs remain constant as activity
changes, it follows that fixed costs per unit vary inversely with activity: As volume increases, unit
cost declines, and vice versa.
Relevant Range
The range over which a company expects to operate during a year is called the relevant range of the
activity in
Mixed Costs: - Mixed costs are costs that contain both a variable element and a fixed element.
Mixed costs, therefore, change in total but not proportionately with changes in the activity level.
Example: The rental of a truck is a good example of a mixed cost. Assume that local rental terms
for a truck, including insurance, are $50 per day plus 50 cents per mile. When determining the cost
of a one-day rental, the per-day charge is a fixed cost (with respect to miles driven), while the
mileage charge is a variable cost. The graphic presentation of the rental cost for a one-day rental is
as follows.
In this case, the fixed-cost element is the cost of having the service available. The variable-cost
element is the cost of actually using the service. Another example of a mixed cost is utility costs
(electric, telephone, and so on), where there is a flat service fee plus a usage charge.
High-Low Method
The high-low method uses the total costs incurred at the high and low levels of activity to classify
mixed costs into fixed and variable components. The difference in costs between the high and low
levels represents variable costs, since only the variable cost element can change as activity levels
change. The steps in computing fixed and variable costs under this method are as follows.
1. Determine variable cost per unit from the following formula.

Variable Cost per Unit = Change in Total Costs  High minus Low Activity Level

To illustrate, assume that Raho Transportation Company has the following assumed maintenance
costs and mileage data for its fleet of buses over a 4-month period.

Month Miles Driven Total Cost

January 20,000 $30,000
February 40,000 48,000
March 35,000 49,000
April 50,000 63,000

2
The high and low levels of activity are 50,000 miles in April and 20,000 miles in January. The
maintenance costs at these two levels are $63,000 and $30,000, respectively. The difference in
maintenance costs is $33,000 ($63,000 - $30,000), and the difference in miles is 30,000 (50,000 -
20,000). Therefore, for Raho Transportation, variable cost per unit is $1.10, computed as follows.
Variable Cost per Unit = $33,000  30,000 miles
= $1.10 per mile.
1. Determine the fixed cost by subtracting the total variable cost at either the high or the low
activity level from the total cost at that activity level. For Raho Transportation, the computations
are shown below:
Raho Transportation Company
Activity Level
High Low
Total cost $63,000 $30,000
Less: Variable costs
50,000 x $1.10 55,000
20,000 x $1.10 22,000
Total fixed costs $ 8,000 $ 8,000

Maintenance costs are therefore $8,000 per month plus $1.10 per mile. This is represented by the
following formula:
Maintenance costs = Fixed costs + ($1.10 x Miles driven)
Hence, for instance, if Raho Transportation mileage data for its fleet of buses for next month is
given to be 45,000 miles, maintenance costs for the moth are computed as follows:
Maintenance costs = $8,000 + ($1.10 x 45,000 Miles)
= $8,000 + $49,500

= $57,500

The high-low method generally produces a reasonable estimate for analysis. However, it does not
produce a precise measurement of the fixed and variable elements in a mixed cost because it ignores
other activity levels in the computation.

To summarize, note the following steps whenever you use High-Low Method:
 Determine the highest and lowest levels of activity.
 Compute variable cost per unit as:
Variable cost per unit = Change in total costs  (High - low activity level).
 Compute fixed cost as:
Fixed cost = Total cost - (Variable cost per unit x Units produced).

Activity 1.1: Do it!

3
Core Company accumulates the following data concerning a mixed cost, using units produced as
the activity level.
Month Units Produced Total Cost
March 40,000 $ 8,500
April 20,000 6,900
May 50,000 4,200
June 10,000 5,800
July 30,000 9,000
Required:
(a) Compute the variable and fixed cost elements using the high-low method.
(b) Estimate the total cost if the company produces:
i) 34,000units.
ii) 48,000units
iii) 16,000units.
iv) 25,000units.
1.2. Cost-Volume-Profit Analysis
Cost-volume-profit (CVP) analysis is the study of the effects of changes in costs and volume on
a company’s profits. CVP analysis is important in profit planning. It also is a critical factor in
such management decisions as setting selling prices, determining product mix, and maximizing
use of production facilities.
The following assumptions underlie each CVP analysis.
1. Behavior of both costs and revenues is linear throughout the relevant range of the activity index.
2. Costs can be classified accurately as either variable or fixed.
3. Changes in activity are the only factors that affect costs.
4. All units produced are sold.
5. When more than one type of product is sold, the sales mix will remain constant. That is,
the percentage that each product represents of total sales will stay the same. Sales mix
complicates CVP analysis because different products will have different cost relationships.
Note that when these assumptions are not valid, the CVP analysis may be inaccurate.
CVP Income Statement

4
 Because CVP is so important for decision making, management often wants this information
reported in a CVP income statement format for internal use. The CVP income statement
classifies costs as variable or fixed and computes a contribution margin. Contribution margin
(CM) is the amount of revenue remaining after deducting variable costs. It is often stated both as
a total amount and on a per unit basis.
To illustrate a CVP income statement, let's consider Alpha Video Company. Alpha Video
produces a high-definition digital video camera. Relevant data for the video cameras sold by this
company in June 2011 are as follows.

Assumed selling and cost data for Alpha Video Company:

Unit selling price of video camera $500
Unit variable costs $300
Total monthly fixed costs $200,000
Units sold 1,500 video cameras

The CVP income statement for Alpha Video therefore would be reported as follows.
ALPHA VIDEO COMPANY
CVP Income Statement
For the Month Ended June 30, 2011
Total PerUnit
Sales (1,500 video cameras) $ 750,000 $ 500
Variable costs (450,000) (300)
Contribution margin $ 300,000 $ 200
Fixed costs (200,000)
Net income $ 100,000

A traditional income statement and a CVP income statement both report the same net income of
$120,000. However a traditional income statement does not classify costs as variable or fixed,
and therefore it does not report a contribution margin. In addition, both a total and a per unit
amount are often shown on a CVP income statement to facilitate CVP analysis.
In the applications of CVP analysis that follow, we assume that the term “cost” includes all costs
and expenses related to production and sale of the product. That is, cost includes manufacturing
costs plus selling and administrative expenses.
Contribution Margin per Unit
Alpha Video’s CVP income statement shows a contribution margin of $320,000, and a
contribution margin per unit of $200 ($500 - $300). The formula for contribution margin per unit
and the computation for Alpha Video are:
Contribution Margin per Unit = Unit Selling Price - Unit Variable Costs

$200 = $500 - $300

11
 Contribution margin per unit indicates that for every video camera sold, Alpha has $200 to cover
fixed costs and contribute to net income. Because Alpha Video has fixed costs of $200,000, it
must sell 1,000 video cameras ($200,000  $200) before it earns any net income. Alpha’s CVP
income statement, assuming a zero net income, is as follows.

ALPHA VIDEO COMPANY

CVP Income Statement
For the Month Ended June 30, 2011
Total PerUnit
Sales (1,000 video cameras) $ 500,000 $ 500
Variable costs (300,000) (300)
Contribution margin $ 200,000 $ 200
Fixed costs (200,000)
Net income $ 0

It follows that for every video camera sold above 1,000 units, net income increases by the amount
of the contribution margin per unit, $200. For example, assume that Alpha sold one more video
camera, for a total of 1,001 video cameras sold. In this case Alpha reports net income of
$200 as shown below:

ALPHA VIDEO COMPANY

CVP Income Statement
For the Month Ended June 30, 2011
Total PerUnit
Sales (1,001 video cameras) $ 500,500 $ 500
Variable costs (300,300) (300)
Contribution margin $ 200,200 $ 200
Fixedcosts (200,000)
Netincome $ 200

Contribution Margin Ratio

Some managers prefer to use a contribution margin ratio in CVP analysis. The contribution
margin ratio is the contribution margin per unit divided by the unit selling price. For Alpha
Video, the ratio is as follows.

Contribution Margin Ratio = Contribution Margin per Unit  Unit Selling Price 40% =
$200  $500

The contribution margin ratio of 40% means that $0.40 of each sales dollar ($1x40%) is available
to apply to fixed costs and to contribute to net income. This expression of contribution

12
 Margin is very helpful in determining the effect of changes in sales on net income. For example,
if sales increase $100,000, net income will increase $40,000 (40% x $100,000). Thus, by using
the contribution margin ratio, managers can quickly determine increases in net income from any
change in sales.

Let's see this effect through a CVP income statement. Assume that Alpha Video’s current sales
are $500,000 and it wants to know the effect of a $100,000 (200-unit) increase in sales. Alpha
prepares a comparative CVP income statement analysis as follows.

ALPHA VIDEO COMPANY

CVP Income Statement
For the Month Ended June 30, 2011
No Change With Change
Total PerUnit Total PerUnit
Sales $ 500,000 $ 500 $ 600,000 $ 500
Variable costs (300,000) (300) (360,000) (300)
Contribution margin $ 200,000 $ 200 $ 240,000 $ 200
Fixed costs (200,000) (200,000)
Net income $ 0 $ 40,000

1.1. Break-Even Analysis Uses and Techniques

A key relationship in CVP analysis is the level of activity at which total revenues equal total
costs (both fixed and variable). This level of activity is called the break-even point. At this
volume of sales, the company will realize no income but will suffer no loss. The process of
finding the break-even point is called break-even analysis. Knowledge of the break-even point is
useful to management when it decides whether to introduce new product lines, change sales
prices on established products, or enter new market areas.
The break-even point can be:
 Computed from a mathematical equation.
 Computed by using contribution margin.
 derived from a CVP graph.
The break-even point can be expressed either in sales units or sales dollars.

Mathematical Equation
The following formula shows a common equation used for CVP analysis.
Sales = Variable Costs + Fixed Costs +Net Income  Basic CVP equation

Identifying the break-even point is a special case of CVP analysis. Because at the break-even point
net income is zero, break-even occurs where total sales equal variable costs plus fixed costs.

13
We can compute the break-even point in units directly from the equation by using unit selling
prices and unit variable costs. The computation for Alpha Video is:
Sales = Variable Costs + Fixed Costs + Net Income
$500Q = $300Q + $200,000 +$0

$200Q = $200,000

Q = 1,000 video cameras

14
 Where,
Q = sales volume in units
$500 = selling price
$300 = variable cost per unit
$200,000 = total fixed costs

Thus, Alpha Video must sell 1,000 units to break even.

To find sales dollars (birr) required to break even, we multiply the units sold at the break-even
point by the selling price per unit, as shown below.
1,000 video cameras x $500 = $500,000 (break-even sales dollars)
Contribution Margin Technique

We know that contribution margin equals total revenues less variable costs. It follows that at the
break-even point, contribution margin must equal total fixed costs. On the basis of this
relationship, we can compute the break-even point using either the contribution margin per unit
or the contribution margin ratio.
When a company uses the contribution margin per unit, the formula to compute break-even point
in units is fixed costs divided by contribution margin per unit. For Alpha Video the computation
is as follows.
Break-even Point in Units = Fixed Costs  Contribution Margin per Unit
1,000 video cameras = $200,000  $200
Formula for break-even point in units using contribution margin

One way to interpret this formula is that Alpha Video generates $200 of contribution margin
with each unit that it sells. This $200 goes to pay off fixed costs. Therefore, the company must
sell 1,000 units to pay off $200,000 in fixed costs. When a company uses the contribution margin
ratio, the formula to compute break-even point in dollars is fixed costs divided by the
contribution margin ratio. We know that the contribution margin ratio for Alpha Video is 40%
($200  $500), which means that every dollar of sales generates 40 cents to pay off fixed costs.
Thus, the break-even point in dollars is:
Break-even Point in Dollars = Fixed Costs  Contribution Margin Ratio

$500,000 = $200,000  40%

Formula for break-even point in dollars using contribution margin ratio

Graphic Presentation
An effective way to find the break-even point is to prepare a break-even graph. Because this
graph also shows costs, volume, and profits, it is referred to as a cost-volume-profit (CVP)
graph.

As the following CVP graph shows, sales volume is recorded along the horizontal axis (x-axis).
This axis should extend to the maximum level of expected sales. Both total revenues (sales) and
15
total costs (fixed plus variable) are recorded on the vertical axis (y-axis).

The construction of the graph, using the data for Alpha Video, is as follows.
1. Plot the total-sales line, starting at the zero activity level. For every video camera sold, total
revenue increases by $500. For example, at 200 units, sales are $100,000. At the upper level
of activity (1,800 units), sales are $900,000. The revenue line is assumed to be linear through
the full range of activity.
2. Plotthetotalfixedcostusingahorizontalline.Forthevideocameras,thislineisplottedat
$200,000. The fixed cost is the same at every level of activity.
3. Plot the total-cost line. This starts at the fixed-cost line at zero activity. It increases by the
variable cost at each level of activity. For each video camera, variable costs are $300. Thus,
at 200 units, total variable cost is $60,000, and the total cost is $260,000. At 1,800 units total
variable cost is $540,000, and total cost is $740,000. On the graph, the amount of the variable
Cost can be derived from the difference between the total cost and fixed cost lines at each
level of activity.
4. Determine the break-even point from the intersection of the total-cost line and the total-
revenue line. The break-even point in dollars is found by drawing a horizontal line from the
break-even point to the vertical axis. The break-even point in units is found by drawing a
vertical line from the break-even point to the horizontal axis. For the video cameras, the
break-even point is $500,000 of sales, or 1,000 units. At this sales level, Alpha Video will

16
 cover costs but make no profit.

The CVP graph also shows both the net income and net loss areas. Thus, the amount of income
or loss at each level of sales can be derived from the total sales and total cost lines. A CVP graph
is useful because the effects of a change in any element in the CVP analysis can be quickly seen.
For example, a 10% increase in selling price will change the location of the total revenue line.
Likewise, the effects on total costs of wage increases can be quickly observed.
1.2. Planning With Cost-Volume-Profit Data
CVP analysis can be used to determine the level of sales needed to achieve a desired level of
profit. Finding the desired profit involves revenue planning, cost planning, and accounting for
the effect of income taxes (when planning for the desired profit after-tax).
Target Net Income
Rather than simply “breaking even,” management usually sets an income objective often called
target net income. It indicates the sales necessary to achieve a specified level of income.
Companies determine the sales necessary to achieve target net income by using one of the three
approaches discussed earlier.
Mathematical Equation
We know that at the break-even point no profit or loss results for the company. By adding an
amount for target net income to the same basic equation, we obtain the following formula for
determining required sales.
Required Sales (in Units) = Variable Costs + Fixed Costs + Target Net Income

required sales may be expressed in either sales units or sales dollars (birr). Assuming that
target net income is $120,000 for Alpha Video, the computation of required sales in units is as
follows.

Required Sales (in Units) = Variable Costs + Fixed Costs + Target Net Income
$500Q = $300Q + $200,000 + $120,000

$200Q = $320,000

Q = 160,000 video cameras

The sales dollars required to achieve the target net income is found by multiplying the units sold
by the unit selling price [(1,600 x $500) = $800,000].
Contribution Margin Technique
As in the case of break-even sales, we can compute in either units or dollars, the sales required to
meet a target net income. The formula to compute required sales in units for Alpha Video using
the contribution margin per unit is as follows.
Fixed Costs + Target Net Income
Required Sales (in Units) =
Contribution Margin per Unit

17
 Q = ($200,000 + $120,000)/$200
Q = ($320,000)/$200
Q = 160,000 video cameras

This computation tells Alpha that to achieve its desired target net income of $120,000, it must
sell 1,600 video cameras. The formula to compute the required sales in dollars for Alpha Video
using the contribution margin ratio is shown below:

Fixed Costs + Target Net Income

Required Sales (in Dollars) =
Contribution Margin Ratio
Q = ($200,000 + $120,000)/40%
Q = ($320,000)/0.4
Q = $800,000
1.3. Effects of Changes on Break-Even Points
a) Effect of Changes in Fixed Costs
Although fixed costs do not change in total with changes in the level of activity, they may
change because of other factors. For example, changes in property tax rates or factory
supervisors’ salaries change fixed costs. Increases in fixed costs will raise the break-even point.
Likewise, decreases in fixed costs will lower the break-even point.

To illustrate, assume that Royal Company is evaluating a proposal to budget an additional

$100,000 for advertising. Fixed costs before the additional advertising are estimated at $600,000,
and the unit contribution margin is $20. The break-even point before the additional expense is
30,000 units, computed as follows:
Fixed Costs
Break-Even Sales (units) =
Unit Contribution Margin
Q = $600,000/$20 = 30,000 units

18
 If the additional amount is spent, the fixed costs will increase by $100,000 and the break-even
point will increase to 35,000 units, computed as follows:
Fixed Costs
Break-Even Sales (units) =
Unit Contribution Margin
Q = $700,000/$20 = 35,000 units

b) Effect of Changes in Unit Variable Costs

Unit variable costs do not change with changes in the level of activity. However, unit variable
costs may be affected by other factors such as changes in the cost per unit of direct materials.
Changes in unit variable costs affect the break-even point as follows:
 Increases in unit variable costs increase the break-even point.
 Decreases in unit variable costs decrease the break-even point.
To illustrate, assume that Park Company is evaluating a proposal to pay an additional 2%
commission on sales to its salespeople as an incentive to increase sales. The data for Park
Company are as follows:
Current Proposed
Unit selling price $250 $250
Unit variable cost 145 150
Unit contribution margin $105 $100
Fixed costs $840,000 $840,000

Park Co.’s break-even point before the additional 2% commission is 8,000 units, as shown
below.
Fixed Costs
Break-Even Sales (units) =
Unit Contribution Margin
Q = $840,000/$105 = 8,000 unit

If the 2% sales commission proposal is adopted, unit variable costs will increase by $5 ($250x2%)
from $145 to $150 per unit. This increase in unit variable costs will decrease the unit contribution
margin from $105 to $100 ($250 - $150).

Thus, Park Co.’s break-even point after the additional 2% commission is 8,400 units, as shown
19
 below.
Fixed Costs
Break-Even Sales (units) =
Unit Contribution Margin
Q = $840,000/$100 = 8,400 units

c) Effect of Changes in Unit Selling Price

Changes in the unit selling price affect the unit contribution margin and, thus, the break-even
point. Specifically, changes in the unit selling price affect the break-even point as follows:
 Increases in the unit selling price decrease the break-even point.
 Decreases in the unit selling price increase the break-even point

To illustrate, assume that Grand Company is evaluating a proposal to increase the unit selling price
of its product from $50 to $60. The data for Grand Company are as follows:
Current Proposed
Unit selling price $50 $60
Unit variable cost 30 30
Unit contribution margin $20 $30
Fixed costs $600,000 $600,000

Grand Co.’s break-even point before the price increase is 30,000 units, as shown below.
Fixed Costs
Break-Even Sales (units) =
Unit Contribution Margin
Q = $600,000/$20 = 30,000 units

The increase of $10 per unit (20% increases) in the selling price increases the unit contribution
margin by $10.

Thus, Grand Co.’s break-even point after the price increase is 20,000 units, as shown below.
Fixed Costs
Break-Even Sales (units) =
Unit Contribution Margin
Q = $600,000/$30 = 20,000 units

20
 Summary of Effects of Changes on Break-Even Point
The break-even point in sales changes in the same direction as changes in the variable cost per
unit and fixed costs. In contrast, the break-even point in sales changes in the opposite direction as
changes in the unit selling price. These changes on the break-even point in sales are summarized
below.
Type of Change Direction of Change Effect of Change on Break-Even Sales
Increase Increase
Fixed cost
Decrease Decrease
Increase Increase
Unit variable cost
Decrease Decrease
Increase Decrease
Unit selling price
Decrease Increase
1.4. Sensitivity Analysis of CVP Results
CVP analysis becomes an important strategic tool when managers use it to determine the
sensitivity of profits to possible changes in costs or sales volume. If costs, prices, or volumes can
change significantly, the firm’s strategy might also have to change. For example, if there is a risk
that sales levels will fall below projected levels, management would be prudent to reduce
planned investments in fixed costs (i.e., investments to increase production capacity). The
additional capacity will not be needed if sales fall, but it would be difficult to reduce the fixed
costs in the short term. Sensitivity analysis is the name for a variety of methods that examine
how an amount changes if factors involved in predicting that amount change. Sensitivity
analysis is particularly important when a great deal of uncertainty exists about the potential level
of future sales volumes, prices, or costs.
In the context of CVP analysis, sensitivity analysis answers questions such as, “What will
operating income be if the quantity of units sold decreases by 5% from the original prediction?”
and “What will operating income be if variable cost per unit increases by 10%?” Sensitivity
analysis broadens managers’ perspectives to possible outcomes that might occur before costs are
committed.
The three of the most common methods for sensitivity analysis are: (1) what-if analysis using
the contribution margin and contribution margin ratio, (2) the margin of safety, and (3)
operating leverage.

(1) What-if analysis is the calculation of an amount given different levels for a factor that
influences that amount. It is a common approach to sensitivity analysis when uncertainty is
present. Many times it is based on the contribution margin and the contribution margin ratio.
For example, the contribution margin ($40) and contribution margin ratio (0.5333) for Global
Company provide a direct measure of the sensitivity of Global Company’s profits to changes
in volume. Each unit change in volume affects profits by $40; each dollar change in sales
affects profits by $0.5333. Use of a spreadsheet such as Excel and tools such as data tables,
scenarios, and goal-seek can facilitate the analysis.
An example of a data table for Global Company is shown below; units sold, fixed cost, and
price are held constant, and we examine the effect of changes in unit variable cost on profits.
Units Sold Unit VC FC Price Profit
21
 (2) Margin of Safety - the margin of safety is the excess of an organization’s expected future
sales (in either revenue or units) above the breakeven point. The margin of safety indicates
the amount by which sales could drop before profits reach the breakeven point:
Margin of safety in units = Actual or estimated Units - Breakeven point Units Margin of safety in revenues =
Actual or estimated revenue - Breakeven point Revenue

The margin of safety is computed using actual or estimated sales values, depending on the
purpose. To evaluate future risk when planning, use estimated sales. To evaluate actual risk when
monitoring operations, use actual sales. If the margin of safety is small, managers may put more
emphasis on reducing costs and increasing sales to avoid potential losses. A larger margin of
safety gives managers greater confidence in making plans such as incurring additional fixed costs.

The margin of safety percentage is the margin of safety divided by actual or estimated sales, in
either units or revenues. This percentage indicates the extent to which sales can decline before
profits become zero.

To illustrate assume that White Company plans to sell 1,000 units at $400 each in the coming
year. White has variable costs of $325 and fixed costs of $45,000.
 Break-even units = F/ (p - v)
 Break-even units = $45,000/ ($400 - $325) = 600 units
 Break-even revenues = 600 units x $400 = $240,000
Required:
(a) Calculate the margin of safety for White in terms of the number of units.
(b)Calculate the margin of safety for White in terms of sales revenue.
(c) Calculate the margin of safety percentage for White in terms of the number of units.
(d)Calculate the margin of safety percentage for White in terms of sales revenue.
Calculation:
(a) Margin of safety in units = 1,000 units - 600 units = 400 units
(b) Margin of safety in sales revenue = $400(1,000) - $400(600) = $160,000
(c) Margin of safety percentage in units = 400 units/1,000 units = 0.4 =40%
(d)Margin of safety percentage in revenues = $160,000/$400,000 = 0.4 =40%
(3) Degree of Operating Leverage: - managers decide how to structure the cost function for
their organizations. Often, potential trade-offs are made between fixed and variable costs. For
example, a company could purchase a vehicle (a fixed cost) or it could lease a vehicle under
a contract that charges a rate per mile driven (a variable cost). Some of the common
advantages and disadvantages of fixed costs are listed below. One of the major disadvantages

22
 of fixed costs is that they may be difficult to reduce quickly if activity levels fail to meet
expectations, thereby increasing the organization’s risk of incurring losses.
Common Advantages Common Disadvantages
 FC might cost less in total than VC.  Investing in fixed resources might divert
management attention away from the
organization’s core competencies.
 Companies might require unique assets  FC typically requires a longer financial
(e.g., expert labor or specialized production Commitment; it can be difficult to reduce them
facilities) that must be acquired through quickly.
long- term commitments.
 Fixed assets such as automation and  Underinvestment or overinvestment in FC
Robotics equipment can significantly improve Could affect profits and may not easily be
operating efficiency. changed in the short term.
 FC is easier to plan; they do not fluctuate with
levels of activity.
The degree of operating leverage is the extent to which the cost function is made up of fixed
costs. Organizations with high operating leverage incur more risk of loss when sales decline.
Conversely, when operating leverage is high an increase in sales (once fixed costs are covered)
contributes quickly to profit. The formula for operating leverage can be written in terms of
either contribution margin or fixed costs, as shown below:
Degree of operating leverage in terms Contribution Margin TR - TVC Q(p-v)
= = =
of contribution margin NI NI NI

F
Degree of operating leverage in terms of fixed costs = + 1
NI

Managers use the degree of operating leverage to gauge the risk associated with their cost
function and to explicitly calculate the sensitivity of profits to changes in sales (units or
revenues):
% change in profit = % change in sales X Degree of operating leverage
To illustrate calculate the degree of operating leverage (DOL) for White Company above.
Calculation:
Contribution Margin 1,000($400 - $325)
DOL = = = 2.5
NI $30,000*
* NI = {1,000($400) - 1,000($325) - $45,000} = $30,000

The degree of operating leverage and margin of safety percentage are reciprocals.

If the margin of safety percentage is small, then the degree of operating leverage is large. In
addition, the margin of safety percentage is smaller as the fixed cost portion of total cost gets
23
larger. As the level of operating activity increases above the breakeven point, the margin of
safety increases and the degree of operating leverage decreases. For White Company, the
reciprocal of the margin of safety percentage is 2.5 (1 0.4). The reciprocal of the degree of
operating leverage is 0.4(12.5).
1.5. Limitations of CVP analysis
The CVP analysis as was stated is a simple and useful concept. But it is based on the above-
mentioned assumptions. These assumptions limit the general applicability of CVP analysis.
These limitations are:
1) Cost segregation problem - Some of the costs can be easily identified as fixed, and
variable. But there are a large number of costs, which belong to a mixed category. In real
world it is very difficult to segregate such mixed costs into variable and fixed.
2) Problem of assuming constant fixed costs - The assumption of constant fixed cost may not
hold true always; for example, if a firm has zero output, some of the supervisors and
executives can be dismissed and salaries (Fixed Costs) can be reduced.
3) Problem of constant variable cost per unit - The assumption of constant variable cost per
unit may also not hold true. Because of efficiencies/inefficiencies of workers due to
experience, and other factors; and the market condition, i.e., change in price of material, etc.
4) Problem of constant selling price per unit - Similarly, selling price rarely remains
constant. Selling price may change because of market conditions.
5) Short-term Focus - The CVP analysis is a short-term technique of profit planning; it cannot
be used for long-range profit planning because of the cost behavior pattern.
Although the CVP analysis suffers from a number of limitations, yet it remains an important
tool of profit planning. What is important is financial analysts should understand the
underlying assumptions and their corresponding limitations.

24
25
26
27
.